Musings on economics and politics, with a special interest in free banking and monetary disequilibrium.

Monday, April 16, 2012

Negative Nominal Interest Rates

Matthew Yglesias seems favorably disposed to a cashless payments system and negative nominal interest rates on bank deposits. Ryan Avent is critical and prefers inflation. This allows for a negative real interest rate on currency and bank deposits.

If the Yglesias plan were to have negative nominal interest rates on bank deposits always, then perhaps Avent would have a point. However, the nominal interest rate on bank deposits can (and should) be varied according to supply and demand.

If issuing money is very costly, perhaps because making loans is very risky, then charging a competitive fee to people who want to hold money clears the market. It simultaneously coordinates the quantity of money with the demand to hold it and saving with investment. (Saving is that part of income not spent on consumer goods and services and investment is spending on capital goods.)

If, on the other hand, issuing money is very profitable, because the loans and other financial assets that banks can fund with it are lucrative, then banks can and should pay positive interest on money. This will still coordinate the quantity of money with the demand to hold it as well as saving and investment.

What is Avent's alternative? Is it to raise the inflation rate whenever the market clearing interest rate needs to be negative? Should the inflation rate then fall again when this is no longer an issue? Or do we have high inflation at all times so that real interest rates can go as negative as necessary with nominal interest remaining above zero? If there were many financial instruments that require negative real interest rates frequently, or even always, this might make some sense. Negative real interest rates would be practically normal and so maybe centering the entire macroeconomic order around allowing for them would make sense. As for the fluctuating inflation approach, varying inflation in final goods prices and wages might be worth it if just about all interest rates needed to be negative sometimes.

But in reality, it is a few, very short and safe financial assets, that only rarely need to have negative real interest rates to clear markets. Painting a picture where all nominal interest rates are temporarily negative, much less permanently negative, is unrealistic. I am sure that neither Yglesias nor Avent have this in mind. Unfortunately, care must be taken not to create that impression.

Generally, interest rates on short and safe assets are lower than on longer and riskier assets. If some interest rates are negative, including on checking account balances, people who want a saving vehicle for retirement or making a down payment on a house would need to save using something that has a longer term to maturity. Those who want more yield, would have to take more risk. Maybe they should consider stocks.

And, of course, if people chose to save by accumulating gold or silver, then there is no problem. The price of gold or silver simply rises enough to clear those markets. Those who were already holding the gold or silver earn capital gains, which allows them to purchase consumer goods or else buy capital goods. And, of course, those accumulating gold or silver bear risk, just as they would if they purchased stocks, risky bonds, or capital goods.

In my view, occasional fluctuations in inflation rates to create occasional negative real yields is needlessly disruptive. Of course, if all prices were perfectly flexible and everyone had a perfect understanding of what is happening, it would hardly matter. But that isn't the real world. I think that slow, steady growth of spending on output is the least bad macroeconomic environment for microeconomic coordination. Spending should grow with the productive capacity of the economy, leaving final goods prices stable on average. Nominal incomes should generally grow with real incomes.

I don't favor keeping the price level absolutely fixed. Decreases the the supplies of particular goods and even slowdowns in productivity should result in a higher price level, and so transitory inflation. And increases in the supplies of particular goods or rapid growth in productivity should have the opposite effect. But creating persistent inflation or fluctuating inflation so that a few asset markets can sometimes have negative real yields is a mistake.

Why is it that real interest rates sometimes need to be negative? We live in an uncertain world where production takes time. Real investment projects involve risk and take time. If someone wants to save but bear no risk and be able to spend their money at any time, then they are proposing to shift risk to someone else. Sometimes, they may have to pay for someone else to bear that risk. The least bad way to handle the situation is for nominal interest rates to be negative on those particular financial assets that require negative real interest rates for quantity supplied to match quantity demanded.

Does this make hand-to-hand currency impossible? Not at all. The problem isn't the existence of hand-to-hand currency. The problem is basing the entire monetary order on government guaranteed hand-to-hand currency. It is perfectly short and perfectly safe and has a zero nominal yield. No other nominal yield can be any lower than the cost of storing currency.

If hand-to-hand currency were privately issued, and there was no effort to make it especially safe and secure, then it could continue to be used for small, face-to-face transactions. It could continue to serve as a medium of exchange. But it would not be a particularly secure store of wealth, and so would not prevent the nominal yields on T-bills or FDIC insured bank deposits from being negative for just as long as necessary to adjust the quantity demanded to the quantity supplied.

Are there alternatives to privatizing currency other than persistent or fluctuating inflation? The alternative is for the government, as issuer of money, to purchase long and risky assets and bear the risk for those who want to hold short and safe assets. Fortunately, this should be no more common than the need for negative nominal interest rates. Interestingly, a monetary order that is committed to heroic open market operations when necessary, much like one that would allow for negative nominal interest rates when needed, might be less likely to have the event occur.

9 comments:

This is interesting commentary. But for now we are in a bind--we have had a deep recession, and a real estate sector still depressed in prices. As long as those prices are depressed, household wealth is crimped and banks have bad loans.

Step One is to reflate real estate, probably through QE and general price inflation.

Step Two may be some of the recommendations we have seen in Market Monetarism blogs, including this one.

Negative real interest rates can arise when a decrease in the desire to spend money on either consumption or investment goods leads to a simultaneous increase in the supply of savings and a decrease in the demand for this larger pool of savings.

As such negative interest real rates are a symptom of the real problem (depressed demand) rather than the problem itself.

I'm struggling a bit to see how negative real interest rates would work even in a world with no cash. Its hard to see a bank offering negative rates attracting many customers (surely people would just move their money to money-like assets that paid at least zero) but a bank offering loans at below zero would have plenty of business. I suspect real interest rate would always hover around zero with huge amounts of money needing to be created to have any effect on AD since the new money would be borrowed and spent on money-like assets in preference to being spent on consumer or investment goods.

Inflation would also allow real interest rates to be below zero - with similar results. In addition inflation would allow relative prices to adjust and help encourage greater investment (particularly if it led to a fall in real wages). However this inflation will be uneven and disruptive in its effects and be a poor way out of the zero-bound.

Bills recommended solution of NGDP targeting could avoid the disadvantages of both these suggestions especially if (as he suggests) expectations about commitment to the target might prevent the lack of confidence that is probably behind the initial fall in demand from taking place in the first place,

I only half get why NGDP targeting is superior to Price level targeting. I see that in an ideal world it would be appropriate to keep NGDP unchanging and have prices fall (or rise) as RGDP rises (or falls). But I am very attracted to the idea that in this ideal world private currency issuers could compete with each other by offering stable purchasing power for their product. This would be attractive to holders of the currency and businesses as it would make economic calculation easy. These private currencies would then practice free-market price-level targeting as they strive to maintain whatever target they advertized for their currency. I just don't see how these private currencies could effect NGDP targeting.

“If someone wants to save but bear no risk and be able to spend their money at any time, then they are proposing to shift risk to someone else.” Not necessarily. My taking less risk than I used to do does not at all imply that someone else must take on more risk; instead, society as a whole can function in a less risky manner.

Bill: "If hand-to-hand currency were privately issued, and there was no effort to make it especially safe and secure, then it could continue to be used for small, face-to-face transactions. It could continue to serve as a medium of exchange. But it would not be a particularly secure store of wealth, and so would not prevent the nominal yields on T-bills or FDIC insured bank deposits from being negative for just as long as necessary to adjust the quantity demanded to the quantity supplied."

Are you sure?

With no Fed, banks would still be members of a private or mutual clearinghouse, and this clearinghouse would have top notch credit. Clearinghouses have historically also issued hand-to-hand currency. If you think the zero bound is a problem, it could remain a problem in a free-banking scenario too.

The Riksbank (aka. Swedish central bank) started paying negative rates on reserve balances in 2009. I don't know what their current policy is. Apparently, it was done at the behest of Governor Lars Svensson, one of Bernanke's old associates at Princeton.

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